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INTERNATIONAL FINANCE

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Title: INTERNATIONAL FINANCE


1
34
INTERNATIONAL FINANCE
CHAPTER
2
Objectives
  • After studying this chapter, you will able to
  • Explain how international trade is financed
  • Describe a countrys balance of payments accounts
  • Explain what determines the amount of
    international borrowing and lending
  • Explain why the United States changed from being
    a lender to being a borrower in the mid-1980s
  • Explain how the foreign exchange value of the
    dollar is determined
  • Explain why the foreign exchange value of the
    dollar fluctuates

3
  • The yen (), the euro (), and the dollar () are
    the worlds three big currencies.
  • Why do currency exchange rates fluctuate?
  • Foreigners are buying up American assets on a big
    scale. Why?

4
Financing International Trade
  • When we buy something from another country, we
    use the currency of that country to make the
    transaction.
  • We record international transactions in the
    balance of payments accounts.
  • Balance of Payments Accounts
  • A countrys balance of payments accounts records
    its international trading, borrowing and lending.

5
Financing International Trade
  • There are three balance of payments accounts
  • Current account
  • Capital account
  • Official settlements account
  • The current account records payments for imports
    of goods and services from abroad, receipts from
    exports of goods and services sold abroad, net
    interest paid abroad, and net transfers (such as
    foreign aid payments).
  • The current accounts balance equals the sum of
    exports minus imports, net interest income and
    net transfers.

6
Financing International Trade
  • The capital account records foreign investment in
    the United States minus U.S. investments abroad.
    (This account also has a statistical discrepancy
    that arises from errors and omissions in
    measuring capital transactions.)
  • The official settlements account records the
    change in U.S. official reserves.
  • U.S. official reserves are the governments
    holdings of foreign currency.
  • If U.S. official reserves increase, the official
    settlements account is negative.
  • The balances of these three accounts sum to zero.

7
Financing International Trade
  • Figure 34.1 shows the balance of payments (as a
    percentage of GDP) over the period 1983 to 2003.

8
Financing International Trade
  • Borrowers and Lenders, Debtors and Creditors
  • A country that is borrowing more from the rest of
    the world than it is lending to it is called a
    net borrower.
  • A country that is lending more to the rest of the
    world than it is borrowing from it is called a
    net lender.
  • The United States is currently a net borrower
    (but as late as the 1970s it was a net lender.)
  • The total net foreign borrowing in the year 2003
    was 4 trillion, about 4 percent of the total
    value of our nations goods and services produced.

9
Financing International Trade
  • A debtor nation is a country that during its
    entire history has borrowed more from the rest of
    the world than it has lent to it.
  • A creditor nation is a country that has invested
    more in the rest of the world than other
    countries have invested in it.
  • The difference between being a borrower/lender
    nation and being a creditor/debtor nation is the
    difference between stocks and flows of financial
    capital.

10
Financing International Trade
  • Being a net borrower is not a problem provided
    the borrowed funds are used to finance capital
    accumulation that increases income.
  • Being a net borrower is a problem if the borrowed
    funds are used to finance consumption.

11
Financing International Trade
  • Current Account Balance
  • The current account balance (CAB) is
  • CAB NX Net interest income Net transfers
  • The main item in the current account balance is
    net exports (NX).
  • The other two items are much smaller and dont
    fluctuate much.

12
Financing International Trade
  • Net Exports
  • Net exports is exports of goods, X, and services
    minus imports of goods and services, M.
  • Net exports are determined by the government
    budget and by private saving and investment.
  • Table 34.2 in the textbook shows the
    relationships among these items and illustrates
    them using the U.S. data for 2003.

13
Financing International Trade
  • The government sector surplus or deficit is equal
    to net taxes, T, minus government purchases of
    goods and services G.
  • The private sector surplus or deficit is saving,
    S, minus investment, I.
  • Net exports is equal to the sum of private sector
    balance and government sector balance
  • NX T G S I

14
Financing International Trade
  • Net exports for the U.S. for 2003 (506 billion)
    equals the sum of private sector balancea
    surplus of 42 billionand government sector
    balancea deficit of 548 billion.

15
Financing International Trade
  • The Three Sector Balances
  • Figure 34.2 shows how the three balances have
    fluctuated for the United States from 1983
    through 2003.

16
Financing International Trade
  • The private sector balance has moved in the
    opposite direction to the government balance.
  • There is not a strong relationship between net
    exports and the other two balances individually.

17
Financing International Trade
  • Is U.S. Borrowing for Consumption or Investment?
  • U.S. borrowing from abroad finances investment.
  • It is much less than private investment and
    almost equal to government investment in public
    infrastructure capital.

18
The Exchange Rate
  • We get foreign currency and foreigners get U.S.
    dollars in the foreign exchange marketthe market
    in which the currency of one country is exchanged
    for the currency of another.
  • The price at which one currency exchanges for
    another is called a foreign exchange rate.
  • Currency depreciation is the fall in the value of
    the currency in terms of another currency.
  • Currency appreciation is the rise in value of the
    currency in terms of another currency.

19
The Exchange Rate
  • Figure 34.3 shows how the exchange rate of the
    yen and the euro for the U.S. dollar have changed
    from 1993 to 2003.
  • Both currencies have fluctuated considerably
    against the U.S. dollar.

20
The Exchange Rate
  • The exchange rate is a price that is determined
    by demand and supply in the foreign exchange
    market.

21
The Exchange Rate
  • Demand in the Foreign Exchange Market
  • The quantity of dollars that traders plan to buy
    in the foreign exchange market during a given
    period depends on
  • The exchange rate
  • Interest rates in the United States and other
    countries
  • The expected future exchange rate

22
The Exchange Rate
  • The Law of Demand for Foreign Exchange
  • The demand for dollars is a derived demand.
  • People buy dollars so that they can buy U.S.-made
    goods and services or U.S. assets.
  • Other things remaining the same, the higher the
    exchange rate, the smaller is the quantity of
    dollars demanded in the foreign exchange market.

23
The Exchange Rate
  • There are two sources of the derived demand for
    U.S. dollars
  • Exports effect
  • Expected profit effect
  • Exports affect The larger the value of U.S.
    exports, the greater is the quantity of dollars
    demanded on the foreign exchange market.
  • And the lower the exchange rate, the greater is
    the value of U.S. exports, so the greater is the
    quantity of dollars demanded.

24
The Exchange Rate
  • Expected profit effect For a given expected
    future U.S. dollar exchange rate, the lower the
    exchange rate, the greater is the expected profit
    from holding U.S. dollars, and the greater is the
    quantity of U.S. dollars demanded on the foreign
    exchange market.

25
The Exchange Rate
  • Figure 34.4 illustrates the demand curve for U.S.
    dollars.

26
The Exchange Rate
  • Changes in the Demand for Dollars
  • A change in any influence on the quantity of
    dollars that people plan to buy, other than the
    exchange rate, brings a change in the demand for
    dollars and a shift in the demand curve for
    dollars.
  • These other influences are
  • Interest rates in the United States and in other
    countries
  • The expected future interest rate

27
The Exchange Rate
  • Interest rates in the United States and in other
    countries The U.S. interest rate minus the
    foreign interest rate is called the U.S. interest
    rate differential.
  • If the U.S. interest differential rises, the
    demand for U.S. dollars increases and the demand
    curve for dollars shifts rightward.
  • The expected future interest rate At a given
    exchange rate, if the expected future exchange
    rate for U.S. dollars rises, the demand for U.S.
    dollars increases and the demand curve for
    dollars shifts rightward.

28
The Exchange Rate
  • Figure 34.5 shows how the demand curve for U.S.
    dollars shifts in response to changes in the U.S.
    interest rate differential and expectations of
    future exchange rates.

29
The Exchange Rate
  • Supply in the Foreign Exchange Market
  • Other things remaining the same, the higher the
    exchange rate, the greater is the quantity of
    dollars supplied in the foreign exchange market.
  • There are two sources of the supply of U.S.
    dollars
  • Imports affect
  • Expected profit effect

30
The Exchange Rate
  • Imports affect The larger the value of U.S.
    imports, the larger is the quantity of dollars
    supplied on the foreign exchange market.
  • And the higher the exchange rate, the greater is
    the value of U.S. imports, so the greater is the
    quantity of dollars supplied.
  • Expected profit effect For a given expected
    future U.S. dollar exchange rate, the lower the
    exchange rate, the greater is the expected profit
    from holding U.S. dollars, and the smaller is the
    quantity of U.S. dollars supplied on the foreign
    exchange market.

31
The Exchange Rate
  • Figure 34.6 illustrates the supply curve of U.S.
    dollars.

32
The Exchange Rate
  • Changes in the Supply of Dollars
  • A change in any influence on the quantity of
    dollars that people plan to sell, other than the
    exchange rate, brings a change in the supply of
    dollars and a shift in the supply curve of
    dollars.
  • These other influences are
  • Interest rates in the United States and in other
    countries
  • The expected future exchange rate

33
The Exchange Rate
  • Interest rates in the United States and in other
    countries If the U.S. interest differential
    rises, the supply for U.S. dollars decreases and
    the supply curve of dollars shifts leftward.
  • The expected future exchange rate At a given
    exchange rate, if the expected future exchange
    rate for U.S. dollars rises, the supply of U.S.
    dollars decreases and the demand curve for
    dollars shifts leftward.

34
The Exchange Rate
  • Figure 34.7 shows how the supply curve of U.S.
    dollars shifts in response to changes in the U.S.
    interest rate differential and expectations of
    future exchange rates.

35
The Exchange Rate
  • Market Equilibrium
  • Figure 34.8 shows how demand and supply in the
    foreign exchange market determine the exchange
    rate.

36
The Exchange Rate
  • If the exchange rate is too high, a surplus of
    dollars drives it down.
  • If the exchange rate is too low, a shortage of
    dollars drives it up.
  • The market is pulled (quickly) to the equilibrium
    exchange rate at which there is neither a
    shortage nor a surplus.

37
The Exchange Rate
  • Changes in the Exchange Rate
  • Changes in demand and supply in the foreign
    exchange market change the exchange rate (just
    like they change the price in any market).
  • If demand increases, the exchange rate rises.
  • If demand decreases, the exchange rate falls.
  • If supply increases, the exchange rate falls.
  • If supply decreases, the exchange rate rises.

38
The Exchange Rate
  • The exchange rate is sometimes volatile because a
    change in the interest differential or in the
    expected future exchange rate change both demand
    and supply and in opposite directions, so they
    bring a large change in the exchange rate.

39
The Exchange Rate
  • Figure 34.9(a) shows that how changes in
    expectations changed the demand for U.S. dollars
    and the supply of U.S. dollars between 1999 and
    2001 and brought a rise in the U.S. dollar
    exchange rate.

40
The Exchange Rate
  • Figure 34.9(b) shows that how changes in
    expectations changed the demand for U.S. dollars
    and the supply of U.S. dollars between 2001 and
    2003 and brought a fall in the U.S. dollar
    exchange rate.

41
The Exchange Rate
  • Exchange Rate Expectations
  • The exchange rate changes when it is expected to
    change.
  • But expectations about the exchange rate are
    driven by deeper forces. Two of them are
  • Purchasing power parity
  • Interest rate parity

42
The Exchange Rate
  • Purchasing power parity A currency is worth the
    value of goods and services that it will buy.
  • The quantity of goods and services that one unit
    of a particular currency will buy will differ
    from the quantity of goods and services that one
    unit of another currency will buy.
  • When two quantities of money can buy the same
    quantity of goods and services, the situation is
    called purchasing power parity.

43
The Exchange Rate
  • If one U.S. dollar exchanges for 100 Japanese
    yen, then purchasing power parity is attained
    when one U.S. dollar buys the same quantity goods
    and services in the United States as 100 yen buys
    in Japan.
  • If one U.S. dollar buys more goods and services
    in the United States than 100 yen buys in Japan,
    people will expect that the dollar will
    eventually appreciate.
  • Similarly, if one U.S. dollar buys less goods and
    services in the United States than 100 yen buys
    in Japan, people will expect that the dollar will
    eventually depreciate.

44
The Exchange Rate
  • Interest rate parity A currency is worth what it
    can earn.
  • The return on a currency is the interest rate on
    that currency plus the expected rate of
    appreciation over a given period.
  • When the returns on two currencies are equal,
    interest rate parity prevails.
  • Market forces achieve interest rate parity very
    quickly.

45
The Exchange Rate
  • The Fed in the Foreign Exchange Market
  • The U.S. interest rate is determined by the
    demand for and supply of money.
  • The Fed determines the supply of money and
    through its influence on the interest rate
    influences the exchange rate.
  • The Fed can also intervene directly in the
    foreign exchange market.
  • If the demand for U.S. dollars falls and the Fed
    wants to hold the exchange rate steady, it can do
    so by buying dollars in the foreign exchange
    market.

46
The Exchange Rate
  • If the demand for dollars increases and the Fed
    wants to hold the exchange rate steady, it can do
    so by selling dollars in the foreign exchange
    market.
  • Figure 34.10 shows how the Fed can achieve a
    target exchange rate in the face of changes in
    the demand for dollars.

47
THE END
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